International finance and economic growth

Despite an abundance of cross‐section, panel, and event studies, there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries. The econometric difficulties are similar to those that bedevil the literature on trade openness and growth, though if anything, they are more severe in the context of international finance. There is also little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies. At the same time, opening the financial account does appear to raise the frequency and severity of economic crises. Nonetheless, developing countries continue to move in the direction of further financial openness.

The paradox that Obstfeld points to is an important one, which has long puzzled me. Why have so many developing countries embraced financial globalization despite the hard-to-locate benefits and all-too-apparent costs? Obstfeld's preferred answer is this:

A plausible explanation is that financial development is a concomitant of successful economic growth, and a growing financial sector in an economy open to trade cannot long be insulated from cross‐border financial flows. This survey discusses the policy framework in which financial globalization is most likely to prove beneficial for developing countries. The reforms developing countries need to carry out to make their economies safe for international asset trade are the same reforms they need to carry out to curtail the power of entrenched economic interests and liberate the economy’s productive potential.

This is an interesting hypothesis, but I am not sure I agree with the final sentence. Some of the most stupendous development successes of our time have been based on subsidized credit, a certain dose of financial repression, development banking, and managed exchange rates, all of which require controlled, rather than liberalized, finance. See South Korea, Taiwan (both of them during the 1960s and 1970s), and China, in particular.

I think an alternative explanation is ideology and the zeitgeist. The dominant narrative of multilateral institutions, the G-7 and most economists has been very kind to financial globalization--lack of evidence notwithstanding. The policy and intellectual climate has been hostile to managing capital flows. So governments have been reluctant to deviate from the norm lest they become identified as renegades.

While we are on international finance, see also Henry from Crooked Timber, who elaborates on the dilemma of global finance in a world of divided sovereignty.

For countries aspiring to affluence (and not just the absence of famine), some measure of financial integration is perceived as inevitable and integral to the kind of capacity building that is necessary to take effective action in the international private and the public sphere.

How does a Korean manager grow comfortable with the idea of expanding internationally if she has never dealt with an international financing deal?

How does a Brazilian central bank official grow comfortable with managing international loans if she has never heard of exchange offers, events of default and restructurings? How then can she be an agent for the national interest in IMF meetings if she has no expertise in these matters?

The only option to some degree of financial integration is hoping that each country can constitute, in isolation, each feature of a fully functioning and developed financial market by fiat and hope to make it spring to life. Good luck with that.

The leakage of know-how that results from financial integration can be immense. Think of accounting convergence, improvements in internal controls, treasury operations, risk management and corporate governance.

In the end this capacity building is also a matter of geopolitics - many countries correctly perceive that their ability to assert a measure of sovereignty and to be effective in international affairs demands some degree of sophistication and skill in handling financial matters.

So the intended results include not only the usual supposed economic benefits - more financing sources and lower cost of capital - but also a more robust, effective and credible private and public sectors.

One of the reasons why it is hard to detect the effect of financial opening on growth and welfare is that financial opening is integral and necessary part of economic convergence. Hence every country beyond a certain income level both adopts open finance and slows down its speed of convergence.

Think about China with 10000 dollars of income per capita (which might happen in our lifetime). Do you think China will have closed finance then?

I really believe that capital account liberalization can´t sustain growth, but, there is compelling evidence that such liberalization leads countries to invest more and to grow faster temporarily. Here is a paper (http://www.nber.org/papers/w12698) that makes the point. I would like to hear your comments.

Unfortunately, I doubt that many governments in poor countries considers the long term. But if capital liberalization gives them a short term political benefit through cheap loans that can be used to pay patronage, they have a short term incentive for the move.

I also agree that your second hypothesis sounds plausible. At least for many countries.

But again, what is the difference between doing what the IMF/WB tells you to do, and pleasing the rich countries? Not much, I guess. And if doing as the IMF tells you to do increases your credit rating and thus the availablity of loans that can be used to reach short-term goals, then we're back to #1 anyways (except for the initial motivation, of course).

Two comments: First let us not forget that frequently the openings, like in Mexico and Venezuela, we mostly a consequence of a disaster.

Second, having seen similar studies draw the most outrageous conclusions basically because they used average data that completely hid the detonating events I believe that to understand the effects an historians approach, a day by day what happened analysis is much more useful. Sorry my econometrical friends. The desk won’t do. You have to walk the streets. (Just as the credit rating agencies should have walked theirs to discover, in time, how sick the subprime mortgages had become).

I too think- as you are alluding to I assume- that the policy recommendations of the G-7 countries more than dominate developing country policy decisions, in regards to financial globalization.

If the policies in the developed countries are 'kind' to financial globalization, then the developing countries have, possibly and to their detriment, been kinder-- to the extent that they have, by design, little or no tax or regulation on globalized capital.

The paradox that Obstfeld points to is an important one, which has long puzzled me. Why have so many developing countries embraced financial globalization despite the hard-to-locate benefits and all-too-apparent costs?

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